Earlier this month, the U.S. Court of Appeals for the Eleventh Circuit relied on the principle ofrespondeat superior to hold a large broker-dealer potentially liable for securities fraud, based upon the unauthorized misstatements about the risks of Auction Rate Securities (ARS) by four of its 1,200 financial advisors. This case, Securities and Exchange Commission v. Morgan Keegan & Company, Inc.,^[1] should serve as a red flag for all investment firms. Under its holding, mistakes in oral information provided to customers by just a handful of low-level employees may be imputed to the firm and result in years of litigation, potential liability to all the firm’s buyers of that product, and costly awards when investments underperform. 

The Pre-Credit Crisis ARS Market

Morgan Keegan was a relatively minor player in the ARS market, underwriting approximately $1.1 billion of ARS that were AAA-rated, issued by municipalities and tax exempt.^[2] Morgan Keegan sold those securities, as well as ARS underwritten by other firms, to its customers. Typically, ARS consist of municipal bonds, corporate bonds and preferred stock and provide for interest payments or dividend yields to the holder that are reset through auctions on regular, short-term bases. Although the securities’ maturity dates were long-term or indefinite, ARS were generally marketed and purchased before the credit crisis on the premise of being highly liquid, short-term investments analogous to money market funds. Holders were paid the interest due on the debt obligations even if they were unable to sell the ARS immediately.

ARS traded in regularly held auctions managed by the underwriting broker-dealers. An auction was deemed to have succeeded if investors submitted sufficient buy orders to cover all the sell orders. To prevent failed auctions, the underwriters (including Morgan Keegan) typically bought their customers’ unsold ARS and held them in their own inventories, thus bolstering the liquidity of the ARS market. No auction for which Morgan Keegan was the lead manager ever failed until February 27, 2008, when the ARS market verged on collapse.

The Collapse of the ARS Market

Before late 2007, ARS auctions rarely failed. The first auction failures occurred in late November 2007 and involved mortgage-backed debt obligations that were neither underwritten nor resold by Morgan Keegan. In the following months, as lenders tightened money supplies and customers rushed to convert ARS into cash, liquidity in the ARS market was disrupted as some ARS underwriters (but not Morgan Keegan) stopped buying their customers’ sell orders.

On February 8, 2008, after the value of its ARS inventory surged from $18 million to $54 million within weeks, Morgan Keegan briefly stopped buying excess sell orders in auctions. The next day, the head of retail trading observed in an email to the head of the retail fixed income desk that customer confidence had been undermined by the underwriters’ failure to support the liquidity of the ARS market. He also speculated that some brokers may not fully understand the ARS product and auction market, adding to the confusion by overstating the safety of ARS to customers or by joining the panic and urging them to sell.

One week later, on February15, the head of the retail fixed income desk described the status of the ARS market in an email to all Morgan Keegan brokers and instructed them to orally relay the information to their customers. The email urged the brokers to slow their customers’ panic-inspired selling by explaining that the turmoil in the ARS market was “liquidity-driven” by the abundance of sellers in the auctions and not “credit-driven” by inability of the bond issuers to pay the interest due on their debt obligations.^[3]

Morgan Keegan resumed purchasing customer ARS at auction for another week until its inventory reached a predetermined cap of approximately $185 million, up from approximately $75 million on February 13, 2008. Without this support, auctions for ARS — in which Morgan Keegan had participated as an underwriter and its customers had invested $2.2 billion, half of which was underwritten by Morgan Keegan — failed.^[4]

The SEC Enforcement Actions

The 2006 Settled Administrative Proceeding. The SEC first looked into the underwriting and auction procedures of ARS underwriters, including Morgan Keegan, in 2006. The result was the entry of a consensual cease-and-desist order for future violations of Section 17(a)(2) of the Securities Act (the so-called “negligent fraud” provision) based on certain alleged auction practices that could favor one customer over another.^[5] The broker-dealers also agreed to provide current ARS customers with a written description of their “material auction practices and procedures,” a duty discharged by notifying first-time buyers of ARS on the back of a confirmation that the information was posted on “a specified web page of the [broker-dealer’s] website…” and would be provided upon request.

In response to the order, Morgan Keegan: (1) developed a 24-page ARS Manual explaining ARS liquidity and the firm’s auction procedures and practices,^[6] sent the Manual to all customers holding ARS at the time it was prepared, and made the Manual available upon request throughout 2007 and 2008; (2) added a similarly detailed ARS section to its Web site and alerted visitors to “Auction Rate Securities Practices and Procedures” inside the Morgan Keegan Web site; (3) added the following language to the back of each ARS trade confirmation: “For information regarding the auction procedures refer to the Morgan Keegan website. Copies available upon request” along with the firm’s Web address; (4) distributed in branch offices and emailed to all its brokers a three-page brochure summarizing investor concerns about ARS^[7]; and (5) issued an annual newsletter to its customers in January 2007 and 2008 directing current and potential ARS investors to its ARS Web page and offering its ARS Manual upon request.

On March 20, 2008, after the collapse of the ARS market, Morgan Keegan required prospective ARS customers to sign a document, titled “Auction Rate Securities Disclosure Letter,” with the following statement: “I understand that many auction rate securities are currently, or have recently, failing at auction. I understand that it may be a considerable period of time before liquidity returns to this investment and I view this with a longer term horizon.”

The Unsuccessful Enforcement Litigation in the Trial Court. On July 21, 2009, in the aftermath of the ARS market failure, the SEC sued Morgan Keegan in federal court in Atlanta alleging fraud under Sections 15(c)(1) and 10(b) of the Securities Exchange Act and SEC Rule 10b-5, and Section 17(a) of the Securities Act.^[8] The SEC conceded the adequacy of Morgan Keegan’s written disclosures, basing its fraud allegations on two theories: (1) supposedly inadequate dissemination of the written warnings about the ARS liquidity and the auction process, and (2) alleged oral statements by four of Morgan Keegan’s 1,200 brokers to four ARS customers contradicting key aspects of the written literature regarding liquidity and the auction process. Although the four customers failed to consult Morgan Keegan’s ARS Manual, Brochure, Web site and annual newsletters, the SEC faulted the brokers for not directing those customers to that universe of written disclosures about ARS liquidity risks. The brokers’ misstatements allegedly included: ARS were as “good as cash,” were “like CDs and money markets,” were “completely liquid [but for] a possible 35-day hold,” were “insured by the FDIC,” and presented “zero concerns” and “zero risk.”^[9]

Morgan Keegan moved for summary judgment, arguing that in light of its extensive written disclosures about the risk of ARS investments, the misstatements of four of the firm’s 1,200 brokers was not material in a securities fraud action against the firm. The district court agreed, observing the SEC had to plead and prove an institutional effort to mislead while noting “the SEC claim[ed] that Morgan Keegan misled the public through the oral statements made to four individuals.”^[10] The district court held: “the oral statements of four brokers out of hundreds would not lead a rational jury to believe that Morgan Keegan, as a whole, misrepresented the risks of ARS investments to its customers….The SEC has to do more than show a few isolated incidents of alleged broker misconduct to obtain [a judgment against the firm].”^[11]

In dismissing the SEC’s case, the district court rejected the notion advocated by the SEC that Morgan Keegan was obligated to provide the written disclosures to every investor and make sure they read it, reciting the familiar rule that Morgan Keegan “needed to make a ‘full and fair disclosure’ to the public, not to any particular investor.”^[12] The trial court held that “Morgan Keegan made various efforts to direct its customers to its Written Disclosures, which adequately described, clearly and efficiently, the risks associated with ARS. With the exercise of reasonable due diligence, any customer could find information regarding the risks associated with the ARS products.”^[13]

The Eleventh Circuit Reverses, Holding Morgan Keegan Potentially Liable for the Losses of All ARS Customers on the Basis of Misstatements of Four Brokers   

On appeal, the U.S. Court of Appeals for the Eleventh Circuit reversed the entry of summary judgment, importing agency law into the inapposite setting of securities fraud to hold that: “[u]nder principles of respondeat superior, Morgan Keegan is liable for the acts of these brokers so long as they acted within the scope of their authority.”^[14] The case was remanded to the district court for further proceedings and trial.^[15]

In finding for the SEC, the Eleventh Circuit assumed the SEC had met the “in connection with” and scienter/negligence elements of securities fraud and focused only on whether the brokers’ statements were material. Ultimately, the issue on appeal was reduced to the classic test ofTSC Industries v. Northway, Inc. — “whether there is a substantial likelihood that the statements would have been viewed by the reasonable investor as having significantly altered the ‘total mix’ of information made available.”^[16] Left unexplained, however, is how the brokers’ statements — unquestionably material in a securities fraud action against the brokers — can be properly imputed to Morgan Keegan, a multi-service investment firm with 1,200 brokers in 300 offices.

Beyond passing reference to respondeat superior,^[17] the Eleventh Circuit made no effort to explain how a common law agency principle can alter the statutory elements of securities fraud action or to harmonize this notion with Janus Capital Group v. First Derivative Traders, Inc.,^[18] in which the Supreme Court held that only the “maker” of the misstatement can be charged with fraud under the securities laws, and then only if the maker also is “that person or entity with ultimate authority over the statement, including its content and whether and how to communicate it.”^[19]

The Eleventh Circuit stopped short of imposing a duty on Morgan Keegan to literally put the written disclosures into the hands of its ARS customers but was dismissive and mocking of Morgan Keegan’s notice on the back of its ARS trade confirmations (that did not explicitly mention “liquidity”), Web site (that was not shown to automatically link to the ARS Web page), Manual (that was not sent to every ARS customer) and Brochure (that was not shown to be available in every Morgan Keegan office). The court also criticized the brokers for failing to point customers to the written disclosures and their precise location.^[20]  

Conclusion

SEC v. Morgan Keegan & Company, Inc. merits watching as it proceeds to trial and possibly through another appeal. This case is highly unusual — and troublesome — if, as the Eleventh Circuit envisions, an investment firm’s liability for securities fraud may turn in large part on the unauthorized alleged oral statements of a handful of low-level employees. As the law of this case continues to develop, those litigating securities fraud claims in the Eleventh Circuit should be sure to make a clear record of the Supreme Court’s Janus Capital requirements that only the “maker” of the misstatement can be charged with fraud under the securities laws, and then only if the maker also is “that person or entity with ultimate authority over the statement, including its content and whether and how to communicate it.”^[21]    

_{[1]2012 U.S. App. LEXIS 8966, No. 11-13992 (11th Cir. May 2, 2012).}

_{[2] Securities and Exchange Commission v. Morgan Keegan & Company, Inc., Civil Action No. 1:09-CV-1965-WSD (N.D. Ga. July 21, 2009). SEC Complaint ¶ 16.}

_{[3] The email stated in part:  “We stress the importance of ignoring the impulse to ‘test’ the process by selling your clients’ ARS holdings in a wholesale manner simply because you or your clients might be worried you will not be able to sell them; we maintain our commitment to supporting the  ARS market to the extent possible, but this is only possible with your cooperation.   Remember, your clients are being well-compensated for holding their ARS positions and  the liquidity concerns should eventually sort themselves out.” Morgan Keegan, 2012  U.S. App. LEXIS 8966, at *7-8.}

_{[4] The ARS market did not entirely dry up since some investors sought out the increased debt service on the debt obligations that came with decreased liquidity. As of July 15, 2009, the date the SEC filed its complaint, Morgan Keegan customers held approximately $272 million of ARS, $50 million of which was underwritten by Morgan Keegan. SEC Complaint ¶ 21.}

_{[5] See, In re Bear, Stearns & Co., et al., Securities Act Release No. 53888, 88 SEC Docket 259 (May 31, 2006).}

_{[6]  For example, the ARS Manual warned investors of the possibility and consequences of auction failures, stating: “Holders who have submitted sell orders should be aware that, in the event of an auction failure, they will not be able to sell all, and may not be able to sell any, securities in the auction.” The Manual also repetitively warned that Morgan Keegan had no obligation to support liquidity and prevent auction failure by purchasing customer ARS.}

_{[7]  The Brochure warned that ARS “involve[] certain risks that differentiate such securities from money market investment instruments,” and described the liquidity risks and uncertainty of the auction process.}

_{[8] Securities and Exchange Commission v. Morgan Keegan & Company, Inc., Civil Action No. 1:09-CV-1965-WSD (N.D. Ga. July 21, 2009).}

_{[9] SEC v. Morgan Keegan & Co., 806 F. Supp. 2d 1253, 1258 (N.D. Ga. 2011), rev’d, 2012 U.S. App. LEXIS 8966; No. 11-13992 (11th Cir. May 2, 2012).}

_{[10] Morgan Keegan, 806 F. Supp. 2d at 1266.}

_{[11] Id. at 1265-66.}

_{[12] Id. at 1261 (citation omitted).}

_{[13] Id. at 1262.}

_{[14] Morgan Keegan, 2012 U.S. App. at 42 (citation omitted).}

_{[15] The SEC’s requested remedies were not limited to redress of harm allegedly incurred by the four investors. Rather, the Complaint sought an order “requiring Morgan Keegan to repurchase all ARS that the Defendant sold prior to March 20, 2008.” SEC Complaint at p. 25.}

_{[16] 96 S. Ct. 2126, 2129 (1976).}

_{[17] Morgan Keegan, 2012 U.S. App. at 42 (citation omitted).}

_{[18] 131 S. Ct. 2296, 2299 (2011).}

_{[19] TSC Industries, 96 S. Ct. at 2129. Under the facts of Morgan Keegan, that question undeniably would be answered in the negative: the substance of customer communications in Morgan Keegan’s ARS Manual, Brochure, Web site, annual letters and supervisors’ emails to All Brokers was formulated and approved by employees with far more seniority in the company hierarchy than the four brokers.}

_{[20] Before the appeal, the SEC dropped a claim that Morgan Keegan improperly sold ARS in January and February 2008 after liquidity issues surfaced in the ARS auction market.}

_{[21] TSC Industries, 96 S. Ct. at 2129.}